This is the reproduction of an article in IFR Asia.

To many global investors, bonds from China’s property sector are toxic nuclear waste, not to be touched at any cost. To others, they come with a more pragmatic “handle with care” warning. I belong to the latter camp.

From just a handful of bonds 10 years ago, the sector has grown to contribute 9.5% of the Asian US dollar bond market with US$51bn of bonds trading. That is nearly a third of all high-yield corporate bonds in the region.

Over this period, the sector has gone through three cycles of downturns and upturns. Several Chinese property companies have issued, redeemed and refinanced their offshore bonds. Companies with credit ratings ranging from Single A to Triple C have managed to issue bonds, which trade actively in the secondary market. Yet, a feeling of unease persists.

Perhaps the first source of discomfort is the fact that offshore Chinese property bonds are deeply subordinated, since they are issued by offshore-incorporated entities, which inject the bond proceeds as equity into their onshore companies and service their debt only out of equity dividends received back from the mainland. The difficulties in repatriating equity funds out of China mean that the offshore principal effectively has to be refinanced. In case of bankruptcy, the onshore lenders have the first claim over the onshore assets.

While this structural weakness is undoubtedly true, it applies to every other bond issued by Chinese businesses, including investment-grade bonds far beyond the property sector, since the structure was born out of regulations prohibiting the issuance of debt or guarantees by mainland companies. (Only recently have the authorities begun to relax this prohibition, and the first few offshore bonds are now coming out with direct guarantees from mainland operating companies.)

ANOTHER SOURCE OF discomfort is the government’s meddling in the property sector through various measures, including the flow of credit to the builders, rules for financing land purchases, obtaining mortgages, and mortgage down-payment requirements. The harshest controls came in 2010 when the government restricted the number of apartments that an individual could purchase.

Property prices are a sensitive subject everywhere, and China is no exception. The government presses the brakes if the prices are speeding too fast and pushes the accelerator if property construction flags too much so as to threaten the overall economic growth.

This government intervention makes asset values volatile in both equity and debt markets, and raises the cost of capital to the sector.

Some investors have also been scared away by stories of oversupply and ghost cities. The property development business model, by definition, consists of a long operating cycle, and there may be genuine demand/supply imbalances, as in any other industry, but the overwhelming majority of Chinese properties are built in response to actual demand from a rapidly urbanising population. The same goes for talk of speculative buying, when the reality is that most of the properties are bought for self-occupation. Buyers have to put up a minimum 30% down-payment, they are not over-leveraged and there is no subprime lending.

WHEN IT COMES to investing in Chinese property bonds, one should realise that there has already been one level of filtering – only those companies large enough to go through a rating process and the expense of issuing offshore actually end up selling dollar bonds. They are all listed offshore, most of them in Hong Kong, and are subject to audits and disclosures that go with the listing status. The additional scrutiny from equity analysts and investors that comes with listing also offers additional information for bond investors.

There has not been a single default in the sector so far, and only two distressed exchanges in 2009, both at 80 cents to the dollar. Some companies did go through financial distress during previous sector downturns, but they managed to sell land or unfinished projects to stronger players and stave off default.

This is not to argue that we would never see a default in the sector. We will, sooner or later. But the sector has genuine fundamentals, strong and weak players, and saleable assets that can be realised in times of distress.

So, how should one approach investments in Chinese property bonds? First of all, investors need to be prepared for the volatility that comes with the regulatory changes. Any crash in value following a regulatory tightening offers an opportunity to pick up the higher-quality bonds at more attractive prices. In fact, such moves also enable the stronger players to buy out the weaker ones or to acquire assets from the struggling players, and increase their market share.

The current downturn in the market is no different. It is true that the stock of unsold property is running above average; that the leverage has increased in the last 12-18 months in response to slowing sales; that margins are under pressure due to the pressure to liquidate stock; and that some of the weaker companies are likely to experience a liquidity crunch in the next 12-18 months, unless they slow down their expansion. But the current downturn is also an opportunity to pick up bonds issued by stronger companies, which will benefit from the tight conditions in the sector. The challenge is reading the credit fundamentals carefully enough to identify the winners.

"It is exceedingly difficult to make predictions, particularly about the future." – Neils Bohr
 
I was remembering my history with forecasts and predictions as I read Nate Silver’s book, “The Signal and The Noise.” I started my career in the Indian financial markets as a credit rating analyst. When we had to make financial forecasts for determining the ratings, we used to make them “conservative” and it was the accepted thing to do. A couple of years later, I switched to being an equity analyst, and I had to make forecasts for a power company. When I made my first recommendation to my boss, he asked me the basis for my forecasts. I told him I was being conservative. I still remember the way he barked at me: “You are not paid to be conservative; you are paid to be correct.”

Over the years, I have made hundreds of corporate financial forecasts, but I always remember that the objective of forecasting is to be as correct as possible. If you are too conservative, you might miss out on good opportunities; but if you are too optimistic, you might get stuck with dud investments.

But I do not understand the false precision in the forecasts of many financial-market analysts. Instead of acknowledging that they can forecast the EPS only within a range, they still provide forecasts to the second decimal place. In predicting macro-economic numbers too, most economists still provide single-point number, rather than a range.

Silver’s book opens with a discussion on the failure of rating agencies to forecast default rates on the U.S. mortgage-backed securities. He runs through some of the familiar ground, including the home speculators’ failure to see that prices could fall, the rating agencies’ failure to see that the quality of the underlying mortgage pool was changing, and the policymakers’ failure to  understand that the housing crisis could have implications spread across the economy.

In another chapter dealing with the failure of economic forecasts, Silver cites studies to show that actual GDP growth fall outside the 90% confidence interval almost half the time. That is a terrible track record, indeed. It is no wonder that the Queen of England asked the economists in the London School of Economics why nobody had noticed the  financial crisis coming. Silver acknowledges that economies are complex  systems, but argues that part of the failure of economic forecasting has to do  with overfitting the data. In other words, there are simply so many economic  variables being measured that you can fit the data to reach any conclusion you want.

He also points out that, even if you manage to choose the right variables to predict the path of the economy, it is  still difficult to separate correlation from causation; economic policymakers observe the same variables and start influencing them through their policies, changing their subsequent behavior. Even more fundamentally, economic data is noisy and subject to many revisions as better estimates become available. And finally, there is the incentive problem: even if an economist is not sure, it benefits him in the long run to issue forecasts as if he is sure!

In contrast to the failure that economic forecasting has been, Silver’s book also provides a fascinating explanation  about another, more successful, area of forecasting complex systems: the  weather. Although the number of variables in the weather system is very large  and the interaction between variables complex, weather forecasting has steadily improved in terms of forecasting accuracy over time. For example, predictions of hurricane paths, temperatures, rainfall and other components of weather have steadily improved as meteorologists have repeatedly used the actual weather to improve their models.

Silver also discusses sports forecasting and political forecasting, the two areas that have won him fame. While it is true that he is generally dismissive of “punditry,” he still finds value in adding judgment to a probabilistic forecast derived from numerical analysis. For me, two of the most fascinating chapters were the one on the probabilities behind poker and the one discussing heuristic models in playing chess. He also discusses the problems with making long-range forecasts, such as global warming models, or forecasting with inadequate feedback, such as with large earthquakes.

While this is not a “how to” manual, the book discusses a lot of relevant concepts such as overfitting, calibration of models, the Bayesean model, and probabilistic thinking. Perhaps the biggest takeaway from the book is to think in terms of probabilities and not single-point forecasts. Among the people in the financial markets, traders are more adept in thinking probabilistically, trying to make a profit in the aggregate, rather than from every single trade.

As a practitioner of forecasting of company financials, I think there are two kinds of forecasts, one based on mass of statistical data (such as sports or weather), and the other based on judgmental systems (such as the financial results of a specific company). In the first, good forecasts depend on the quality of the data and the forecasting models, both of which can be refined over time. In the latter, the challenges are greater because you are trying to predict the behavior of a single firm based on economic, sectoral, technological and regulatory trends. Even if your underlying predictions of business trends are correct, the company’s management may still surprise you by its actions, say, an acquisition or entry into a new business. I believe it is important not to shy away from making forecasts of the big trends and their impacts, but one should not get too focused on single numbers of single years. 

Besides getting the overall trend and turning points correct, one also has to get the magnitude and timing correct in order to make money in the markets. Otherwise, one can keep issuing bearish forecasts in the hope of being eventually correct (a la Nouriel Roubini!)

Nate Silver’s book is an important and entertaining read for anyone in the prediction business. 

Many times, I have felt that India is like a bowl of spaghetti. In such a diverse country with so many things going on at any time, it is difficult to sort out the issues and make sense of what needs to be done. 

In the book, “Imagining India”, Nandan Nilekani (co-founder and ex-CEO of Infosys and the current head of the national identity card project) tries to view the country in terms of the ideas that define it. He sorts them into four categories: ideas that have been accepted in the society; those that are under progress; those about which there is still considerable debate and disagreement; and those that will be relevant for the future, but are not receiving the attention they deserve.

As I kept reading the book, I found myself arguing with the author. While I had my  preconceptions, I also found myself learning many new facts about India. Nilekani's understanding of the country is impressive, and his arguments are supported by well-researched data and statistics. As a co-founder of Infosys and one of the corporate leaders of India, he has had tremendous access to other leaders: finance ministers, Nobel Prize winners, economists, social workers, historians, and even a foreign country's prime minister.

This book is a "must-read" for anyone interested in understanding today's India and its future. It is the most balanced of the three books that I read recently about India, the other two being "India: The Emerging Giant" by Arvind Panagariya and "The Indian Renaissance: India's Rise after a Thousand Years of Decline" by Sanjeev Sanyal. Panagariya's book is packed with facts and figures, but much of it historical; Sanyal's book is good, good but does not address the challenges deeply. Nilekani's book not only discusses the issues deeply, but provides enough facts to support the arguments.

Accepted Ideas

Nilekani starts the first section with the argument that India has finally started viewing its people as assets rather than liabilities. He cites the now-famous concept of demographic dividend as the foundation of India's future. Of course, having led Infosys for many years, Nilekani cites the IT and BPO sectors as evidence of the positive role that a well-educated population could play. But as I read the chapter, I kept wondering if his views were not tainted by his IT  experience. For instance, he does mention the fact that the southern states have  crossed their peak period of demographic dividend, while the population of the lower-developed BIMARU (Bihar, Madhya Pradesh, Rajasthan and Uttar Pradesh) states are still growing and getting younger. But he does not discuss the implications of this split fully. Unless the BIMARU states manage to develop, and that too at a rapid pace, the population profile of those states may become a curse, and the current regional imbalances may intensify and lead to social problems.

Besides, how can one conclude that the human population of India has become its asset, when over 60% of the population still depends on agriculture for a living, and even in that sector, the labor productivity is very poor? Whether India's young demographic profile may turn into a blessing or a curse depends on how well other areas of the economy are reformed to produce the growth and jobs necessary to satisfy the people. And that is where Nilekani's other ideas become relevant.

Nilekani next discusses the acceptance of entrepreneurs in the society. He traces the dominating influence of Nehru's socialist policies on India's early economic path as an independent country, and their failure to produce  sustainable growth. He then goes on to discuss the Bombay Plan devised by the industrialists as a compromise to the fiercely socialist government, and describes the eventual rise of the entrepreneur after Manmohan Singh's 1991
liberalization. As I read the chapter, I could not but feel angry and disappointed at the missed economic opportunities, thanks to the failed Nehruvian policies. I also remembered the futile rules that curtailed production of various products, even as demand was booming. (My father wanted to buy a Bajaj scooter in 1987 and found that he had to place a deposit and wait for three years for his turn to buy one; so he  eventually bought one in the black market by paying a premium of about 25% of the actual cost, and had to run the scooter in someone else's name for a year before it could be transferred to his name!).

The overall thrust of the argument that private enterprise is now encouraged is fine, but it is difficult to agree with Nilekani when he says that the ineffectual economic policies are what bought the Congress down finally and led to the rise of multi-party democracy. In fact, in many other parts of the book, he does a masterly job of describing the rise of multiple identities that led to a regional and multi-party political system.

The other problem with this chapter, and indeed the whole book, is that Nilekani scarcely mentions the role of corruption in holding down India's development. There is no doubt that the nexus between the politicians, bureaucrats and businessmen twisted the system to their benefit rather than that of the common people. This omission also made me think about Dhirubhai Ambani, who had brilliant ideas about business (in particular, his conviction to build world-scale capacities and his use of capital markets), but who nevertheless manipulated the system to his unashamed advantage, including blatant scandals such as smuggling and duplicate share certificates. But now, there is even a book on “Ambanism” as if it is a legitimate economic philosophy!

The next accepted idea that Nilekani talks about is the growing use of English across the country and its almost universal acceptance by politicians. No disputes on this point, happily! It reminded me of a discussion in my business school about what unites India. After considering different ideas, we settled upon commerce and business that keeps India united. English is, of course, the glue that links Indians and keeps the commerce flowing.

Next to come is IT, Nilekani's home subject. His description of how Rajiv Chawla, a cunning bureaucrat, slipped computerization quietly into the land records system of Karnataka is hilarious. The government workers had not realized what was going on, and by the time they woke up, it had been done! It is indeed heartening to see IT being used in many key private sectors, such as banking, railways and insurance, and it is seeping into core government services.

When Nilekani talks about globalization as an accepted idea, he again falls back on IT as the main example. While that is indisputable, there is much work to be done to reap the benefits of globalization in the manufacturing, agriculture and financial sectors. There are good examples of some Indian manufacturing companies benefiting from access to global markets, but what has been achieved falls far short of the overall potential of the country. I am also not sure how Indian agriculture would react to globalization in terms of input and output pricing, as well as product choice. For instance, what kind of crops might be produced if all input and output are priced at international levels? Or, what kind of agricultural imports and exports might take place? Will Indian agriculture benefit from globalization without first eliminating the structural inefficiencies such as small farm holdings and land ceiling legislations? These are complex questions, but Nilekani does not carry the argument about agricultural globalization to its logical end. While he has covered so many important aspects in the book, I wish he had discussed the agricultural sector more thoroughly, instead of just mentioning it in passing in different contexts.

Nilekani's final accepted idea is democracy, and it is also one which I found most difficult to digest. For all its positives and ills, democracy is an idea that has finally been accepted in India as the political system of choice. Nilekani has provided a good description of the rise of regional parties and factions, but it is not clear what his judgment is about the phenomenon: is he just describing, bemoaning or celebrating? He argues that the caste, language and regional identities grew in prominence due to the failure of the state to provide  broad-based growth. The question is not whether India has accepted democracy, but whether the current form of democracy is not turning into kleptocracy.

He believes that the new identities are coalescing into an Indian identity, but in my view, he is treading on thin ice when he says that. On the other hand, I feel that the multi-identity democracy is serving to hinder progress rather than enable it; and whatever progress is achieved is in spite of it rather than due to it. After all, how many regional parties have an overarching view of Indian progress and society? How many of them function on the basis of any principle, except that of taking care of their own supporters and constituents? At the extreme instances, when I think about the unprincipled bargaining between different parties, I only get the image of hyenas tearing at the prey from different directions, getting their fill of the meat. Finally, even Nilekani is forced to acknowledge the inescapable, but he still gives it a positive spin when he says, “this period of stonewalling, backtracking and accommodation is essential ... it is the only way we can frame policies that are truly sustainable.” It is a shame that even after 60 years of independence, a discerning writer like Nilekani has to call India's democracy young in trying to justify what is happening.